Cryptocurrency, or a digital unit of value known under the broad definition of virtual currency, is now a thriving mainstream investment medium. The IRS has been hard at work trying to determine how and when to tax these investments and has gradually determined their reporting requirements. Before we get into the reporting requirements, here are a couple simplified explanations of common crypto terms to help understand what the IRS is referring to:
Cryptocurrency – a type of virtual currency that utilizes cryptography (think secret codes and ciphers) to securely record digital transactions on a distributed ledger. Bitcoin is one of the most widely recognizable cryptocurrencies, with a few others being Ethereum and Tether. At the time of this article’s publication, there were almost 3,000 different cryptocurrencies being actively traded with a total market capitalization of $221B. If that isn’t enough to convince you cryptocurrencies are here to stay in a big way, Facebook is also working on setting up its own cryptocurrency for all its users, known as Libra, with an initial release targeted for 2020.
Distributed Ledger – a data registry that houses transactions that include, but is not limited to, cryptocurrency exchange. Blockchain is just one of the available ledger technologies but is generally the most well-known. Blockchain gets its name from the simplistic explanation of what makes up a distributed ledger - blocks of transactions/data chained together. Each block contains all the data from the previous block (all the way from inception) and continues growing with each new transaction. All of this information is stored in a decentralized manner, or in multiple locations instead of just one, typically across a variety of servers (or on an individual’s machine who is referred to as a miner). When a new transaction occurs, all the servers are synchronized with the new information. This new information cannot be deleted and becomes a part of the permanent data chain. By keeping the information decentralized, synchronized, and permanent, it enables the data to be protected from intentional malicious alterations.
Distributed ledgers come in two forms - public and private. Generally, most are public which means they are available for the public to view through special web browsers or other software. Though a user’s identity is most often encrypted, the rest of the transaction detail can be seen (date, time, etc.). In recent years, the IRS has demanded and been granted access to see passed the encryption for some cryptocurrencies. This means they can get their hands on the full transaction detail in order to begin enforcing reporting requirements.
This brings us to IRS Notice 2014-21. This notice is where the IRS determined cryptocurrencies are considered property for tax purposes and not a legal US tender. The taxation effects of this are as follows:
All reporting must be done in US Dollars. And because cryptocurrency is not considered a currency by the IRS, there will be no foreign currency gain or loss for US federal tax purposes.
Any cryptocurrency bought and sold will be treated the same as other property. This means that every time a cryptocurrency is purchased (or new ones are mined), the fair market value (FMV) at the date of purchase (or mining) becomes the taxpayer’s cost basis. At the time of sale, if that FMV has increased, the taxpayer must report a capital gain. If the FMV has decreased and total losses for the year exceed total gains, a taxpayer may write off the loss up to $3,000 per year, with any remaining loss amounts carried forward for future write off/gain offset. In other words, cryptocurrency is taxed in the same fashion as a typical stock purchase/sale (e.g. Amazon stock).
Cryptocurrencies received in exchange for goods or services are taxable income at the FMV on the date of receipt. If an independent contractor is paid more than $600 for goods or services, the payer must file a Form 1099 to report the miscellaneous income and the contractor will likely be required to report it as self-employment (SE) income. If the cryptocurrency is paid to an employee as a wage, the FMV is reportable on Form W2 and is subject to withholding, FICA, and unemployment taxes.
Mining companies may have to pay SE taxes on the income they receive from the mining and selling of cryptocurrencies and may also have to pick up that income as ordinary (as opposed to the typical capital gains associated with property). Additionally, other companies that hold cryptocurrencies for sale will report any income as ordinary and may be required to pay SE tax on the income as well.
This article only scratches the surface of the complexities involved with cryptocurrency and taxation. IRS enforcement is coming and this will be an area of scrutiny in the future. Failing to report these transactions increases your risk for an audit and may lead to significant penalties and interest. If you are actively trading, mining, or paying/receiving cryptocurrencies, consult with your tax advisor regarding your individual situation so that you aren’t met with an unexpected tax liability at the end of the year.